The Cost of Capital Approach Suggests That Disney Should Do the Following…

The cost of capital approach suggests that Disney should do the following…

¨ Disney currently has $15.96 billion in debt. The optimal dollar debt (at 40%) is roughly $55.1 billion. Disney has excess debt capacity of 39.14 billion. ¨ To move to its optimal and gain the increase in value, Disney should borrow $ 39.14 billion and buy back stock. ¨ Given the magnitude of this decision, you should expect to answer three questions: ¤ Why should we do it? ¤ What if something goes wrong? ¤ What if we don’t want (or cannot ) buy back stock and want to make investments with the additional debt capacity?

Aswath Damodaran 55 Why should we do it? Effect on Firm Value – Full Valuation

Step 1: Estimate the cash flows to Disney as a firm EBIT (1 – Tax Rate) = 10,032 (1 – 0.361) = $6,410 + Depreciation and amortization = $2,485 – Capital expenditures = $5,239 – Change in noncash working capital $0 Free cash flow to the firm = $3,657 ¨Step 2: Back out the implied growth rate in the current market value Current enterprise value = $121,878 + 15,961 - 3,931 = 133,908 Value of firm = $ 133,908 = FCFF (1+g) 3, 657(1+g) 0 = (Cost of Capital -g) (.0781 -g) Growth rate = (Firm Value * Cost of Capital – CF to Firm)/(Firm Value + CF to Firm) = (133,908* 0.0781 – 3,657)/(133,908+ 3,657) = 0.0494 or 4.94% ¨Step 3: Revalue the firm with the new cost of capital FCFF (1+g) 3, 657(1.0494) ¤Firm value = 0 = = $172, 935 million (Cost of Capital -g) (.0716 -0.0484)

¤Increase in firm value = $172,935 - $133,908 = $39,027 million

Aswath Damodaran 56 Effect on Value: Incremental approach

¨ In this approach, we start with the current market value and isolate the effect of changing the capital structure on the cash flow and the resulting value. Enterprise Value before the change = $133,908 million Cost of financing Disney at existing debt ratio = $ 133,908 * 0.0781 = $10,458 million Cost of financing Disney at optimal debt ratio = $ 133,908 * 0.0716 = $ 9,592 million Annual savings in cost of financing = $10,458 million – $9,592 million = $866 million Annual Savings next year $866 Increase in Value= = = $19, 623 million (Cost of Capital - g) (0.0716 - 0.0275)

Enterprise value after recapitalization = Existing enterprise value + PV of Savings = $133,908 + $19,623 = $153,531 million

Aswath Damodaran 57 From firm value to value per share: The Rational Investor Solution

¨ Because the increase in value accrues entirely to stockholders, we can estimate the increase in value per share by dividing by the total number of shares outstanding (1,800 million). ¤ Increase in Value per Share = $19,623/1800 = $ 10.90 ¤ New Stock Price = $67.71 + $10.90= $78.61 ¨ Implicit in this computation is the assumption that the increase in firm value will be spread evenly across both the stockholders who sell their stock back to the firm and those who do not and that is why we term this the “rational” solution, since it leaves investors indifferent between selling back their shares and holding on to them.

Aswath Damodaran 58 The more general solution, given a buyback price

¨ Start with the buyback price and compute the number of shares outstanding after the buyback: ¤ Increase in Debt = Debt at optimal – Current Debt ¤ # Shares after buyback = # Shares before – Increase in Debt Share Price ¨ Then compute the equity value after the recapitalization, starting with the enterprise value at the optimal, adding back cash and subtracting out the debt at the optimal: ¤ Equity value after buyback = Optimal Enterprise value + Cash – Debt ¨ Divide the equity value after the buyback by the post- buyback number of shares. ¤ Value per share after buyback = Equity value after buyback/ Number of shares after buyback

Aswath Damodaran 59 Let’s try a price: What if can buy shares back at the old price ($67.71)?

¨ Start with the buyback price and compute the number of shares outstanding after the buyback ¤ Debt issued = $ 55,136 - $15,961 = $39,175 million ¤ # Shares after buyback = 1800 - $39,175/$67.71 = 1221.43 m ¨ Then compute the equity value after the recapitalization, starting with the enterprise value at the optimal, adding back cash and subtracting out the debt at the optimal: ¤ Optimal Enterprise Value = $153,531 ¤ Equity value after buyback = $153,531 + $3,931– $55,136 = $102,326 ¨ Divide the equity value after the buyback by the post- buyback number of shares. ¤ Value per share after buyback = $102,326/1221.43 = $83.78

Aswath Damodaran 60 Back to the rational price ($78.61): Here is the proof

¨ Start with the buyback price and compute the number of shares outstanding after the buyback ¤ # Shares after buyback = 1800 - $39,175/$78.61 = 1301.65 m ¨ Then compute the equity value after the recapitalization, starting with the enterprise value at the optimal, adding back cash and subtracting out the debt at the optimal: ¤ Optimal Enterprise Value = $153,531 ¤ Equity value after buyback = $153,531 + $3,931– $55,136 = $102,326 ¨ Divide the equity value after the buyback by the post- buyback number of shares. ¤ Value per share after buyback = $102,326/1301.65 = $78.61

Aswath Damodaran 61 2. What if something goes wrong? The Downside Risk 62

¨ Sensitivity to Assumptions A. “What if” analysis The optimal debt ratio is a function of our inputs on operating income, tax rates and macro variables. We could focus on one or two key variables – operating income is an obvious choice – and look at history for guidance on volatility in that number and ask what if questions. B. “Economic Scenario” Approach We can develop possible scenarios, based upon macro variables, and examine the optimal debt ratio under each one. For instance, we could look at the optimal debt ratio for a cyclical firm under a boom economy, a regular economy and an economy in recession. ¨ Constraint on Bond Ratings/ Book Debt Ratios Alternatively, we can put constraints on the optimal debt ratio to reduce exposure to downside risk. Thus, we could require the firm to have a minimum rating, at the optimal debt ratio or to have a book debt ratio that is less than a “specified” value.

Aswath Damodaran 62 Disney’s Operating Income: History

Recession Decline in Operating Income Standard deviation in % 2009 Drop of 23.06% change in EBIT = 19.17% 2002 Drop of 15.82% 1991 Drop of 22.00% 1981-82 Increased by 12% Aswath Damodaran Worst Year Drop of 29.47% 63 Disney: Safety Buffers?

Aswath Damodaran 64 Constraints on Ratings

¨ Management often specifies a 'desired rating' below which they do not want to fall. ¨ The rating constraint is driven by three factors ¤ it is one way of protecting against downside risk in operating income (so do not do both) ¤ a drop in ratings might affect operating income ¤ there is an ego factor associated with high ratings ¨ Caveat: Every rating constraint has a cost. ¤ The cost of a rating constraint is the difference between the unconstrained value and the value of the firm with the constraint. ¤ Managers need to be made aware of the costs of the constraints they impose.

Aswath Damodaran 65 Ratings Constraints for Disney

¨ At its optimal debt ratio of 40%, Disney has an estimated rating of A. ¨ If managers insisted on a AA rating, the optimal debt ratio for Disney is then 30% and the cost of the ratings constraint is fairly small: Cost of AA Rating Constraint = Value at 40% Debt – Value at 30% Debt = $153,531 m – $147,835 m = $ 5,696 million ¨ If managers insisted on a AAA rating, the optimal debt ratio would drop to 20% and the cost of the ratings constraint would rise: Cost of AAA rating constraint = Value at 40% Debt – Value at 20% Debt = $153,531 m – $141,406 m = $ 12,125 million

Aswath Damodaran 66 3. What if you do not buy back stock..

¨ The optimal debt ratio is ultimately a function of the underlying riskiness of the business in which you operate and your tax rate. ¨ Will the optimal be different if you invested in projects instead of buying back stock? ¤ No. As long as the projects financed are in the same business mix that the company has always been in and your tax rate does not change significantly. ¤ Yes, if the projects are in entirely different types of businesses or if the tax rate is significantly different.

Aswath Damodaran 67 Extension to a family group company: Tata Motor’s Optimal Capital Structure

Tata Motors looks like it is over levered (29% actual versus 20% optimal), perhaps because it is drawing on the debt capacity of other companies in the Tata Group.

Aswath Damodaran 68 Extension to a firm with volatile earnings: Vale’s Optimal Debt Ratio

Replacing Vale’s current operating income with the average over the last three years pushes up the optimal to 50%.

Aswath Damodaran 69 Optimal Debt Ratio for a young, growth firm: Baidu

The optimal debt ratio for Baidu is between 0 and 10%, close to its current debt ratio of 5.23%, and much lower than the optimal debt ratios computed for Disney, Vale and Tata Motors.

Aswath Damodaran 70 Extension to a private business Optimal Debt Ratio for Bookscape

Debt value of leases = $12,136 million (only debt) Estimated market value of equity = Net Income * Average PE for Publicly Traded Book Retailers = 1.575 * 20 = $31.5 million Debt ratio = 12,136/(12,136+31,500) = 27.81%

The firm value is maximized (and the cost of capital is minimized) at a debt ratio of 30%. At its existing debt ratio of 27.81%, Bookscape is at its optimal.

Aswath Damodaran 71 The US Tax Reform Act of 2017: Effects on the Optimal Debt Ratio 72

¨ Change in marginal tax rate: The marginal federal tax rate for US companies on US income has been lowered from 35% to 21%. Holding all else constant, that will lower the optimal debt ratio for all firms. ¨ Limits on interest tax deduction: Companies can deduct interest expenses only up to 30% of EBITDA (until 2022) and 30% of EBIT (after 2022). That will add a constraint to the tax savings from debt. In the cost of capital calculation, it will show up in the tax rate that you use to compute your after- tax cost of debt, lowering the tax rate from the marginal if interest expenses> 30% of EBITDA: Tax rate if Interest Expense> 30% of EBITDA = Marginal Tax rate * (.30*EBITDA)/ Interest Expense

Aswath Damodaran 72 Effect on tax code on Debt Impact: Disney in 2018 73

Aswath Damodaran 73 Are US companies adjusting to the new tax code? 74

Debt Load at US Ciompaniwa $10,000 4.00

$9,000 3.50

$8,000 3.00 $7,000

2.50 $6,000

$5,000 2.00

$4,000 1.50

$3,000 1.00 $2,000

0.50 $1,000

$- 0.00 2017 2018 2019

Total Debt Total Debt with Leases Debt to EBITDA

Aswath Damodaran 74 Limitations of the Cost of Capital approach

¨ It is static: The most critical number in the entire analysis is the operating income. If that changes, the optimal debt ratio will change. ¨ It ignores indirect bankruptcy costs: The operating income is assumed to stay fixed as the debt ratio and the rating changes. ¨ Beta and Ratings: It is based upon rigid assumptions of how market risk and default risk get borne as the firm borrows more money and the resulting costs.

Aswath Damodaran 75 II. Enhanced Cost of Capital Approach

¨ Distress cost affected operating income: In the enhanced cost of capital approach, the indirect costs of bankruptcy are built into the expected operating income. As the rating of the firm declines, the operating income is adjusted to reflect the loss in operating income that will occur when customers, suppliers and investors react. ¨ Dynamic analysis: Rather than look at a single number for operating income, you can draw from a distribution of operating income (thus allowing for different outcomes).

Aswath Damodaran 76 Estimating the Distress Effect- Disney

Rating Drop in EBITDA Drop in EBITDA Drop in EBITDA (Low) (Medium) (High) To A No effect No effect 2.00% To A- No effect 2.00% 5.00% To BBB 5.00% 10.00% 15.00% To BB+ 10.00% 20.00% 25.00% To B- 15.00% 25.00% 30.00% To C 25.00% 40.00% 50.00% To D 30.00% 50.00% 100.00%

Aswath Damodaran 77 The Optimal Debt Ratio with Indirect Bankruptcy Costs 78

Cost of Bond Interest rate Cost of Debt Enterprise Debt Ratio Beta Equity Rating on debt Tax Rate (after-tax) WACC Value 0% 0.9239 8.07% Aaa/AAA 3.15% 36.10% 2.01% 8.07% $122,633 10% 0.9895 8.45% Aaa/AAA 3.15% 36.10% 2.01% 7.81% $134,020 20% 1.0715 8.92% Aaa/AAA 3.15% 36.10% 2.01% 7.54% $147,739 30% 1.1769 9.53% Aa2/AA 3.45% 36.10% 2.20% 7.33% $160,625 40% 1.3175 10.34% A2/A 3.75% 36.10% 2.40% 7.16% $172,933 50% 1.5573 11.72% C2/C 11.50% 31.44% 7.88% 9.80% $35,782 60% 1.9946 14.24% Caa/CCC 13.25% 22.74% 10.24% 11.84% $25,219 70% 2.6594 18.07% Caa/CCC 13.25% 19.49% 10.67% 12.89% $21,886 80% 3.9892 25.73% Caa/CCC 13.25% 17.05% 10.99% 13.94% $19,331 90% 7.9783 48.72% Caa/CCC 13.25% 15.16% 11.24% 14.99% $17,311

The optimal debt ratio stays at 40% but the cliff becomes much steeper.

Aswath Damodaran 78 Extending this approach to analyzing Financial Service Firms 79

¨ Interest coverage ratio spreads, which are critical in determining the bond ratings, have to be estimated separately for financial service firms; applying manufacturing company spreads will result in absurdly low ratings for even the safest banks and very low optimal debt ratios. ¨ It is difficult to estimate the debt on a financial service company’s balance sheet. Given the mix of deposits, repurchase agreements, short-term financing, and other liabilities that may appear on a financial service firm’s balance sheet, one solution is to focus only on long-term debt, defined tightly, and to use interest coverage ratios defined using only long-term interest expenses. ¨ Financial service firms are regulated and have to meet capital ratios that are defined in terms of book value. If, in the process of moving to an optimal market value debt ratio, these firms violate the book capital ratios, they could put themselves in jeopardy.

Aswath Damodaran 79 Capital Structure for a bank: A Regulatory Capital Approach

¨ Consider a bank with $ 100 million in loans outstanding and a book value of equity of $ 6 million. Furthermore, assume that the regulatory requirement is that equity capital be maintained at 5% of loans outstanding. Finally, assume that this bank wants to increase its loan base by $ 50 million to $ 150 million and to augment its equity capital ratio to 7% of loans outstanding. Loans outstanding after Expansion = $ 150 million Equity after expansion = 7% of $150 = $10.5 million Existing Equity = $ 6.0 million New Equity needed = $ 4.5 million ¨ Your need for “external” equity as a bank/financial service company will depend upon a.Your growth rate: Higher growth -> More external equity b.Existing capitalization vs Target capitalization: Under capitalized -> More external equity c.Current earnings: Less earnings -> More external equity d.Current dividends: More dividends -> More external equity

Aswath Damodaran 80 Deutsche Bank’s Financial Mix

Current 1 2 3 4 5 Asset Base 439,851 € 453,047 € 466,638 € 480,637 € 495,056 € 509,908 € Capital ratio 15.13% 15.71% 16.28% 16.85% 17.43% 18.00% Tier 1 Capital 66,561 € 71,156 € 75,967 € 81,002 € 86,271 € 91,783 € Change in regulatory capital 4,595 € 4,811 € 5,035 € 5,269 € 5,512 € Book Equity 76,829 € 81,424 € 86,235 € 91,270 € 96,539 € 102,051 €

ROE -1.08% 0.74% 2.55% 4.37% 6.18% 8.00% Net Income -716 € 602 € 2,203 € 3,988 € 5,971 € 8,164 € - Investment in Regulatory Capital 4,595 € 4,811 € 5,035 € 5,269 € 5,512 € FCFE -3,993 € -2,608 € -1,047 € 702 € 2,652 € The cumulative FCFE over the next 5 years is -4,294 million Euros. Clearly, it does not make the sense to pay dividends or buy back stock.

Aswath Damodaran 81 Financing Strategies for a financial institution

¨ The Regulatory minimum strategy: In this strategy, financial service firms try to stay with the bare minimum equity capital, as required by the regulatory ratios. In the most aggressive versions of this strategy, firms exploit loopholes in the regulatory framework to invest in those businesses where regulatory capital ratios are set too low (relative to the risk of these businesses). ¨ The Self-regulatory strategy: The objective for a bank raising equity is not to meet regulatory capital ratios but to ensure that losses from the business can be covered by the existing equity. In effect, financial service firms can assess how much equity they need to hold by evaluating the riskiness of their businesses and the potential for losses. ¨ Combination strategy: In this strategy, the regulatory capital ratios operate as a floor for established businesses, with the firm adding buffers for safety where needed..

Aswath Damodaran 82 Determinants of the Optimal Debt Ratio: 1. The marginal tax rate 83

¨ The primary benefit of debt is a tax benefit. The higher the marginal tax rate, the greater the benefit to borrowing:

Aswath Damodaran 83 2. Pre-tax Cash flow Return

Enterprise Optimal Optimal Debt Company EBITDA EBIT Value EBITDA/EV EBIT/EV Debt Ratio Disney $12,517 $10,032 $133,908 9.35% 7.49% $55,136 40.00% Vale $20,167 $15,667 $112,352 17.95% 13.94% $35,845 30.00% Tata Motors 250,116₹ 166,605₹ 1,427,478₹ 17.52% 11.67% 325,986₹ 20.00% Baidu ¥13,073 ¥10,887 ¥342,269 3.82% 3.18% ¥35,280 10.00% Bookscape $4,150 $2,536 $42,636 9.73% 5.95% $13,091 30.00%

Higher cash flows, as a percent of value, give you a higher debt capacity, though less so in emerging markets with substantial country risk.

Aswath Damodaran 84 3. Operating Risk

¨ Firms that face more risk or uncertainty in their operations (and more variable operating income as a consequence) will have lower optimal debt ratios than firms that have more predictable operations. ¨ Operating risk enters the cost of capital approach in two places: ¤ Unlevered beta: Firms that face more operating risk will tend to have higher unlevered betas. As they borrow, debt will magnify this already large risk and push up costs of equity much more steeply. ¤ Bond ratings: For any given level of operating income, firms that face more risk in operations will have lower ratings. The ratings are based upon normalized income.

Aswath Damodaran 85 4. The only macro determinant: Equity vs Debt Risk Premiums 86

Equity Risk Premiums and Bond Default Spreads 7.00% 9.00

Median ERP/ Baa Spread during period = 2.02 8.00 6.00% 7.00 5.00% 6.00

4.00% 5.00

3.00% 4.00

3.00 ERP / Baa Spread Premium (Spread) 2.00% 2.00 1.00% 1.00

0.00% 0.00 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

ERP /Baa Sp read Baa - T.Bond Rate ERP

Aswath Damodaran 86 6 Application Test: Your firm’s optimal financing mix

¨ Using the optimal capital structure spreadsheet provided: 1. Estimate the optimal debt ratio for your firm 2. Estimate the new cost of capital at the optimal 3. Estimate the effect of the change in the cost of capital on firm value 4. Estimate the effect on the stock price ¨ In terms of the mechanics, what would you need to do to get to the optimal immediately?

Aswath Damodaran 87 Return Spreads Globally….